Want to Understand Money?

This was published on January 2, 2013, in Ron Paul’s Monetary Policy Anthology: Materials From the Chairmanship of the Subcommittee on Domestic Monetary Policy and Technology, US House of Representatives, 112th Congress.

The scholarly contributions of Murray N. Rothbard span numerous disciplines, and may be found in dozens of books and thousands of articles. But even if we confine ourselves to the topic of money, the subject of this volume, we still find his contributions copious and significant.

As an American monetary historian Rothbard traced the party politics, the pressure groups, and the academic apologists behind the various national banking schemes throughout American history. As a popularizer of monetary theory and history he showed the public what government was really up to as it took greater and greater control over money. As a business cycle expert he wrote scholarly books on the Panic of 1819 and the Great Depression, finding the roots of both in artificial credit expansion. And while the locus classicus of monetary theory in the tradition of the Austrian School is Ludwig von Mises’ 1912 work The Theory of Money and Credit, the most thorough shorter overview of Austrian monetary theory is surely chapter 10 of Rothbard’s treatise Man, Economy and State.

Rothbard placed great emphasis on the central monetary insight of classical economics, namely that the quantity of money is unimportant to economic progress. There is no need for the money supply to be artificially expanded in order to keep pace with population, economic growth, or any other factor. As long as prices are free to fluctuate, changes in the purchasing power of money can accommodate increases in production, increases in money demand, changes in population, or whatever. If production increases, for example, prices simply fall, and the same amount of money can now facilitate an increased number of transactions commensurate with the greater abundance of goods. Any attempt by "monetary policy" to keep prices from falling, to accommodate an increase in the demand for money, or to establish "price stability," will yield only instability, entrepreneurial confusion, and the boom-bust cycle. There is no way for central bank policy or any form of artificial credit expansion to improve upon the micro-level adjustments that take place at every moment in the market.

With the exception of the Austrian School of economics, to which Rothbard made so many important contributions throughout his career, professional economists have treated money as a good that must be produced by a monopoly – either the government itself or its authorized central bank. Rothbard, on the other hand, teaches that money is a commodity (albeit one with unique attributes) that can be produced without government involvement. Rothbard’s history of money, in fact, is a history of small steps, the importance of which are often appreciated only in hindsight, by which government insinuated its way into the business of money production.

It was Carl Menger who demonstrated how money could emerge on the free market, and Ludwig von Mises who demonstrated that it had to emerge that way. In this as in so many other areas, Mises broke with the reigning orthodoxy, which in this case held that money was a creation of the state and held its value because of the state’s seal of approval. A corollary of the Austrian view was that fiat paper money could not simply be created ex nihilo by the state and imposed on the public. The fiat paper we use today would have to come about in some other way.

It was one of Rothbard’s great contributions to show, in his classic What Has Government Done to Our Money? and elsewhere, the precise steps by which the fiat money in use throughout the world came into existence. First, a commodity money (for convenience, let’s suppose gold) comes into existence on the market, without central direction, simply because people recognize that the use of a highly valued good as a medium of exchange, as opposed to persisting in barter, will make it easier for them to facilitate their transactions. Second, money substitutes began to be issued, and circulate instead of the gold itself. This satisfies the desires of many people for convenience. They would rather carry paper, redeemable into gold, than the gold itself. Finally, government calls in the gold that backs the paper, keeps the gold, and leaves the people with paper money redeemable into nothing. These steps, in turn, were preceded by the seemingly minor – but in retrospect portentous indeed – government interventions of monopolizing the mint, establishing national names for the money in a particular country (dollars, francs, etc.), and imposing legal tender laws.

Rothbard also brought the Austrian theory of the business cycle to a popular audience. Joseph Salerno, who has been called the best monetary economist working in the Austrian tradition today, was first drawn to the Austrian School by Rothbard’s essay "Economic Depressions: Their Cause and Cure." There Rothbard laid out the problems that business cycle theory needed to solve. In particular, any theory of the cycle needed to account, first, for why entrepreneurs should make similar errors in a cluster, when these entrepreneurs have been chosen by the market for their skill at forecasting consumer demand. If these are the entrepreneurs who have done the best job of anticipating consumer demand in the past, why should they suddenly do such a poor job, and all at once? And why should these errors be especially clustered in the capital-goods sectors of the economy?

According to Rothbard, competing theories could not answer either of these questions satisfactorily. Certainly any theory that tried to blame the bust on a sudden fall in consumer spending could not explain why consumer-goods industries, as an empirical fact, tended to perform relatively better than capital-goods industries.

Only the Austrian theory of the business cycle adequately accounted for the phenomena we observe during the boom and bust. The cause of the entrepreneurial confusion, according to the Austrians, is the white noise the Federal Reserve introduces into the system by its manipulation of interest rates, which it accomplishes by injecting newly created money into the banking system. The artificially low rates mislead entrepreneurs into a different pattern of production than would have occurred otherwise. This structure of production is not what the free market and its price system would have led entrepreneurs to erect, and it would be sustainable only if the public were willing to defer consumption and provide investment capital to a greater degree than they actually are. With the passage of time this mismatch between consumer wants and the existing structure of production becomes evident, massive losses are suffered, and the process of reallocating resources into a sustainable pattern in the service of consumer demand commences. This latter process is the bust, which is actually the beginning of the economy’s restoration to health.

The concentration of losses in the capital-goods sector can be explained by the same factor: the artificially low interest rates brought about by the Fed’s intervention into the economy. What Austrians call the higher-order stages of production, the stages farthest removed from finished consumer goods, are more interest-rate sensitive, and will therefore be given disproportionate stimulus by the Fed’s policy of lowering interest rates.

Equipped with this theory, Rothbard wrote America’s Great Depression(1963). There Rothbard did two things. First, he showed that the Great Depression had not been the fault of "unregulated capitalism." After explaining the Austrian theory of the business cycle and showing why it was superior to rival accounts, Rothbard went on to apply it to the most devastating event in U.S. economic history. In the first part of his exposition, Rothbard focused on showing the extent of the inflation during the 1920s, pointing out that the relatively flat consumer price level was misleading: given the explosion in productivity during the roaring ’20s, prices should have been falling. He also pointed out how bloated the capital-goods sector became vis-a-vis consumer goods production. In other words, the ingredients and characteristics of the Austrian business cycle theory were very much present in the years leading up to the Depression.

Second, Rothbard showed that the persistence of the Depression was attributable to government policy. Herbert Hoover, far from a supporter of laissez-faire, had sought to prop up wages during a business depression, spent huge sums on public works, bailed out banks and railroads, increased the government’s role in agriculture, impaired the international division of labor via the Smoot-Hawley Tariff, attacked short sellers, and raised taxes, to mention just a portion of the Hoover program.

Rothbard had been interested in business cycles since his days as a graduate student. He had intended to work on a history of American business cycles for his Ph.D. dissertation under Joseph Dorfman at Columbia University, but he found out that the first major cycle in American history, the Panic of 1819, provided ample material for study in itself. That dissertation eventually appeared as a book, via Columbia University Press, called The Panic of 1819: Reactions and Policies (1962). In that book, which the scholarly journals have declared to be the definitive study, Rothbard found that a great many contemporaries identified the Bank of the United States – which was supposed to be a source of stability – as the primary culprit in that period of boom and bust. American statesmen who had once favored such banks, and who thought paper money inflation could be a source of economic progress, converted to hard money on the spot, and proposals for 100-percent specie banking proliferated.

In A History of Money and Banking: The Colonial Era to World War II, a collection of Rothbard’s historical writings published after the author’s death, Rothbard traced the history of money in the United States and came up with some unconventional findings. The most stable period of the nineteenth century from a monetary standpoint turns out to be the period of the Independent Treasury, the time when the banking system was burdened with the least government involvement. What’s more, the various economic cycles of the nineteenth century were consistently tied to artificial credit expansion, either participated in or connived at by government and its privileged banks. Rothbard further showed that the traditional tale of the 1870s, when the United States was supposed to have been in the middle of the "Long Depression," was all wrong. This was actually a period of great prosperity, Rothbard said. Years later, economic historians have since concluded that Rothbard’s position had been the correct one.

Rothbard’s treatment of the Federal Reserve System itself, which he dealt with in numerous other works, involved the same kind of analysis that historians like Gabriel Kolko and Robert Wiebe applied to other fruits of the Progressive Era. The conventional wisdom, as conveyed in the textbooks, is that the Progressives were enlightened intellectuals who sought to employ the federal regulatory apparatus in the service of the public good. The wicked, grasping private sector was to be brought to heel at last by these advocates of social justice.

New Left revisionists demonstrated that this version of the Progressive Era was nothing but a caricature. The dominant theme in Progressive thought was expert control over various aspects of society and the economy. The Progressives were not populists. They placed their confidence in a technocratic elite administering federal agencies removed from regular public oversight. What’s more, the resulting regulatory apparatus tended to favor the dominant firms in the market, which is why the forces of big business were in sympathy with, rather than irreconcilably opposed to, the Progressive program. "With such powerful interests as the Morgans, the Rockefellers, and Kuhn, Loeb in basic agreement on a new central bank," Rothbard wrote, "who could prevail against it?"

It is with these insights in mind that Rothbard scrutinized the Federal Reserve. He would have none of the idea that the Fed was the creation of far-seeing public officials who sought to subject the banking system to wise regulation for the sake of the people’s well-being. The Fed was created not to punish the banking system, but to make its fractional-reserve lending operate more smoothly. In The Case Against the Fed, What Has Government Done to Our Money?, and The Mystery of Banking, Rothbard took the reader through the step-by-step process by which the banks engaged in credit expansion, earning a return by lending money created out of thin air. Without a central bank to coordinate this process, Rothbard showed, the banks’ position was precarious. If one bank inflated more than others, those others would seek to redeem those notes for specie and the issuing bank would be unable to honor all the redemption claims coming in.

The primary purpose of the central bank, therefore, in addition to propping up the banks through its various liquidity injections and its position as the lender of last resort, is to coordinate the inflationary process. When faced with the creation of new money by the Fed, the banks will inflate on top of this new money at the same rate (as determined by the Fed’s reserve requirement for banks). Therefore, the various redemptions will tend, on net, to cancel each other out. This is what Rothbard meant when he said the central bank made it possible to "inflate the currency in a smooth, controlled, and uniform manner throughout the nation."

Although Rothbard distinguished himself as a monetary theorist and as a monetary historian, he did not confine himself to theory or history. He devoted plenty of attention to the here and now – to critiques of Federal Reserve policy, for example, or to criticisms of government responses to the various fiascoes, the Savings and Loan bailout among them, to which our financial system is especially prone. He likewise looked beyond the present system to a regime of sound money, and in The Case for a 100 Percent Gold Dollar and The Mystery of Banking laid out a practical, step-by-step plan to get there from here.

In his work on monetary theory and history, as in his work in so many other areas, Rothbard showed from both an economic and a moral point of view why a system of liberty was preferable to a system of government control. At a time when the political class and the banking establishment are being subjected to more scrutiny than ever, the message of Rothbard takes on a special urgency.

For that reason we should all be grateful that his monetary work, and that of the other great Austrian economists, is being carried on by Murray Rothbard's friend and colleague Ron Paul. By my reckoning, no one in history has brought true monetary theory and history to a larger audience.